- Scott Poore, AIF, AWMA, APMA
Hell Bent And Fancy Free
For some strange reason, the Fed appears to be "hell bent" on raising rates next month. Fed speakers have been largely hawkish in speeches this week. And yet, there seems little concern that the markets barely avoided would could have been a disastrous banking crisis. In fact, Fed speakers seem to be ignoring previous public comments in order to plow forward with their plan. It reminds me of the odd, but famous movie, "Dr. Strangelove."
The movie was released in theaters in 1964, at the height of the Cold War and after the Cuban Missile Crisis in 1962. The movie is relevant today as we are living in a world of contradictions and shifting definitions. The movie itself is a little hard to watch and typical of the type of film director Stanley Kubrick is famous for making. The movie realized average receipts at the box office, only grossing about $9 million worldwide on a budget of almost $2 million. Here are some interesting tidbits about the film:
Peter Sellers, who played Dr. Strangelove in the film, earned $1 million for his role, which was about 55% of the entire film's budget.
While shooting some aerial footage for the film over Greenland, the camera crew's plane was mistaken for a Soviet spy plane as it passed over a secret U.S. military base. (spoiler alert - the film is about a nuclear World War III scenario between the U.S. and the then Soviet Union)
George C. Scott, another famous actor in the film, was annoyed with director Kubrick, who he claimed, was pushing him to overact. He vowed never to work with Kubrick again - and didn't.
This was the film debut of one of America's more beloved actors, James Earl Jones, who played a military officer in the movie. Funny note, Jones initially thought Slim Pickens was staying in character off camera, until being told he wasn't putting on the character, that's the way he always talked.
While the movie didn't do especially well at the box office, it was nominated for 4 Oscars and is often listed among the top 100 movies of all time.
Here's what we've seen so far this week...
Hawks Come Out Firing. At this point, I'm not really sure what the Fed is doing. The hawks at the Fed came out firing this week and caused equities to take a little pause. Before we get into the comments, a reminder might be apropos that inflation has declined for 9 consecutive months from it's peak (a first in the last 70 years).
Now, on to the hilarity. This week, Governor Bostic (Atlanta) stated that his baseline was for one more hike (next month) and leaving rates there for "quite some time." Next was Governor Williams (New York), who is consistently hawkish. He stated that "inflation is still too high" but that "inflation is moderating." Next was Governor Logan (Dallas), though fairly neutral on the FOMC, who stated he was "watching for further sustained improvement in inflation." Last was Governor Mester (Cleveland) who also stated "inflation is still too high" and that the "Fed has more work to do." It's almost as if Stanley Kubrick is directing these Fed governors into "over acting" in their comments.
In the film, Dr. Strangelove, as the President and his Joint Chiefs are hunkered down in the Pentagon War Room, a skirmish breaks out between a couple of individuals. The President excoriates the men and says, "Gentlemen, you can't fight in here! This is the War Room." What a contradiction in terms - can't fight in a war room. Just like inflation is "moderating" and needs further "sustained" improvement - after nine consecutive months of declines. The Fed wants to get the terminal rate above 5% and that's what they're going to do - come hell or high water. This stands in stark contrast to Chairman Powell and Treasury Secretary Yellen telling the public they would be watching the data - they aren't.
Fed futures show an 84% probability of a 25 basis point rate hike next month. Remember when Chairman Powell stated that tightening credit conditions might be a proxy for another rate hike? According to the Fed's Beige Book, released earlier this week, "Lending volumes and loan demand generally declined across consumer and business loan types. Several Districts noted that banks tightened lending standards amid increased uncertainty and concerns about liquidity." The reality is that because of the Fed's actions, M2 (Money Supply) has contracted for 6 consecutive months. The goal of fighting inflation has been accomplished.
Fancy Free Attitude. Considering that we just narrowly escaped a banking crisis, the Fed is rather blase about raising rates another 25 basis points. While the panic from the SVB debacle is behind us, the banking situation is still in flux. Over the past 4 weeks, the usage of the Fed's Discount Window and the new Bank Term Funding Program (BTFP) has declined - until this week. It would appear that banks did access those two programs with slightly higher demand (increase from $139.5 billion to $143.9 billion).
While one Fed governor (Goolsbee) has acknowledged the still fluid banking situation, the other hawks that have spoke this week seem to focus on noting but inflation (which we have already addressed). While bank earnings for Q1 have proven so far to have avoided a disastrous outcome, the results are far from stellar. While close to 70% of the bank earnings released this week exceeded analysts estimates, some of the regional banks (Regions, Fifth Third, Texas Capital, and Truist) fell short of earnings expectations.
Fortunately, a lot of the withdrawals from banks have slowed since the banking crisis began and investors are moving away from Money Markets. In fact, more than $68 billion came out of Money Markets over the past week - the largest weekly decline since July, 2020. We renew our our concern that the Fed should tread lightly given the current situation. Another rate hike for the mere sake of hitting a previously stated terminal rate instead of adjusting to the data would be a mistake - and potentially costly, at that.
Speaking of "fancy free," there is a new federal rule going into effect after May 1st that will affect mortgages in a similar fashion to pre-2007. According to the new rule, homebuyers with credit scores of 680 or higher will pay more for their monthly mortgage to help subsidize home purchases for those with riskier credit ratings. It would appear that we learned nothing from the real estate circus that led to the 2008 Financial Crisis. In the mid-2000s, mortgage originations were lowered to allow those who could not afford a home to purchase it anyway. This led to homeowners unable to meet their mortgage debts and a financial crisis resulted.
In 2007, the average credit score for a homebuyer fell to 710, which resulted in too many homebuyers because banks were originating loans that were too risky. Credit scores have already dropped in recent years as the "free" money floating around during COVID led to those with lower credit scores acquiring a mortgage. If those with higher credit scores are used to subsidize those with lower credit scores, one of two things might happen - those with higher scores may wait on a home purchase or those with riskier scores acquire a mortgage when they cannot truly afford it. Either one would be bad for the mortgage market. It's somewhat reminiscent of the point in Dr. Strangelove when one of the generals chastises the President for worrying about how he might be perceived after a war. That general states, "Perhaps it might be better, Mr. President, if you were more concerned with the American People than with your image in the history books." Another mistake in the mortgage market could cost the American People another recession like 2008, when that situation can be avoided if we learn from history.
Can We Avoid A Recession? The answer is absolutely. However, it's going to depend upon how the consumer holds up over the next few months. The good news is there are green shoots that investors and consumers need to keep in mind. In the film Dr. Strangelove, the debate among the key advisors to the President is how to avoid a complete global war. At one point the President offers to let the Russian Ambassador into the War Room.
One of the irate generals tells the President, "Sir, you can't let him in here. He'll see everything. He'll see the big board." However, in that particular scenario, when staring down the destruction of humanity, calmer heads should prevail. That's exactly what investors need to keep in mind.
Unlike 2007, when the Index went into positive territory 4 months before the recession began, and 2020, when the Index went from negative to positive in a matter of just a few weeks, the Index has been in negative territory since July of 2020. Almost 90% of the 105 contributors tracked by the Index are looser than average. The Bloomberg Financial Conditions Index, which is more sensitive than the ANCFI, has also made a dramatic improvement since the beginning of the banking crisis.
That index has gone from negative to positive over the last four weeks. In fact, Fed member Bullard (St. Louis) is so confident in another rate hike that he stated this week, "Wall Street’s very engaged in the idea there’s going to be a recession in six months or something, but that isn’t really the way you would read an expansion like this." One measure that would help Bullard's view is the Global Purchasing Managers Index. The preliminary reading for April showed a much higher increase than expected. Economists had expected the reading to come in at 52.8, but the number was actually 53.5. A reading above 50 indicates economic expansion. In fact, the survey behind the index showed that there was an uptick in orders and greater consumer confidence than the previous month's survey. As we stand here now, we have to take the position that a recession is not imminent. The data can change, and we'll let the data change our mind when the time comes. Until then, we expect equities to continue the grind higher.
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